Close-Out Netting
Close-out netting is a settlement mechanism used for over-the-counter derivatives transactions. The parties may also enter into transactions under a so-called netting agreement between them.
Netting agreements provide that, irrespective of the number of transactions the parties have entered into with each other, there is in effect only one agreement between them, such that individual transactions cannot be treated as individual agreements. Under a netting agreement, should one firm become insolvent (firm ABC) before all outstanding transactions have expired, the counterparty (firm XYZ) will be entitled to terminate all outstanding transactions under the netting agreement. After having terminated the transactions, XYZ can calculate the losses it has suffered as a result of the termination. Whilst it will have suffered losses from the termination of those transactions in which it was in-the-money, the termination of transactions in respect of which it was out-of-the-money would be a gain to it.
ABC will aggregate these positive and negative amounts and the resulting sum will represent the single amount of money which the insolvent firm owes the solvent firm. If the result is a negative sum, the solvent firm must pay the defaulting firm. This single net sum is the only amount which is owed by one party to the other under the netting agreement.
Netting Reduces Credit Risk
The benefits of close-out netting are risk reduction and cost reduction. The risk reduction is twofold: reduction of credit risk and reduction of systemic risk. The reduction in credit risk can best be achieved when each transaction is entered into as part of a single netting agreement, in a legal environment that recognizes the enforceability of close-out netting. Accordingly, ABC'S exposure to XYZ under all of its in-the-money transactions (gross exposure) is reduced to the single net amount owed to ABC. Obviously, if XYZ is in-the-money with respect to the net amount calculated under the netting agreement, then XYZ will be the party that can reduce its counterparty risk.
The widespread use ofInternational Swaps and Derivatives Association master agreements providing for close-out netting also has an important beneficial effect on systemic risk. Market participants face a considerable exposure to risks stemming from the failure of a major market participant causing cascading insolvencies through counterparties. Close-out netting not only reduces credit risk, but also decreases the chances of cascading insolvencies. By reducing counterparty exposure at each node in the network of relationships between market participants, close-out netting lessens the chance of cascading insolvencies.
Netting Law In Hungary
Where close-out netting is uncertain credit risk cannot be reduced and parties must calculate their credit exposures on a gross, rather than a net basis. Until the end of last year there was doubt over the enforceability of close-out netting in Hungary. It was unclear whether the court would recognize close-out netting as a legitimate method of calculating loss or would treat such a mechanism as a set-off for in-the-money and out-of-the-money transactions. The restrictions on effecting set-off against an insolvent Hungarian counterparty made the outcome of the solvent party's attempt to enforce close-out netting uncertain. There was also a risk that the court would regard close-out netting as an arrangement, the aim of which was to deceive other creditors.
On Dec. 18 the Hungarian parliament passed Act CXX of 2001 on the Capital Markets (the "CMA") the provisions of which addressed the above concerns. The CMA amended the relevant provisions of Act XLIX of 1991 on bankruptcy, liquidation and voluntary winding ups (the "Bankruptcy Act"). Under the amended provisions close-out netting of derivative, repo and similar financial transactions pursuant to a netting agreement is a legal and enforceable mechanism for calculating a claim against an insolvent counterparty. Parties are specifically authorized by the Bankruptcy Act to submit to the insolvency officer their net claim calculated accordingly. Also, the Bankruptcy Act makes it clear that close-out netting cannot be treated by any person as an agreement the purpose of which is to defraud other creditors and decrease the assets of the debtor. Finally, the CMA defines the term close-out netting and the definition is sufficiently broad to include the latest derivatives products in the calculation mechanism.
Legal certainty for close-out netting of OTC derivatives transactions will reduce costs for banks, will encourage foreign financial institutions to deal with Hungarian entities and, therefore, will stimulate the growth and competitiveness of financial markets in Hungary.
Zoltán Lengyel, senior associate at Allen & Overy in Budapest, Hungary.
